Taxes 2011 – 10 Tips to Avoid an Audit

Take it from someone who’s been there: An IRS audit is no walk in the park.

My first (and hopefully last) office audit was more than 20 years ago. I’ll never forget the letter the accountant I hired to represent me – also a personal friend – sent me. It said, in part: “Don’t worry – we’ll fight this to your last dollar.”

If memory serves, I came out of my audit unscathed. But it’s like going to the dentist: Even if you don’t have any cavities, it’s still nothing resembling a good time.

You’ll see any number of articles suggesting that there’s a path you can take that will ensure you’ll slip by unnoticed. There isn’t. Nobody outside of the agency really knows why or how the IRS picks returns for further study. Like Coca-Cola, the formula is a secret. In addition, some returns are chosen randomly, so even if you had the inside scoop, you could still end up in audit-city.

There are, however, past patterns, statements from the agency and other direct and indirect indications of potential audit triggers. So while there’s no set of instructions guaranteed to keep the tax man away, there are things you can do to try to minimize your odds.

The first three are in the following video – check it out, then meet me on the other side for more.

To recap those tips, three things to avoid are using a preparer that’s on the IRS’s radar, claiming hobby expenses as business deductions, and claiming any kind of deductions that are large relative to your income. But, as I said in that story, if you’re entitled to a deduction, by all means, take it. Just be prepared to prove your case should your return be flagged.

Now, let’s look at some other things that might draw the eye of the IRS…

7 more things you can do to minimize your audit odds

1. Don’t make mistakes on your return. We did a post a couple of weeks ago called Avoiding 13 Common Mistakes, so I won’t repeat them here. But it’s common sense to assume that the more mistakes you make, the more your return will stick out. So make sure your math is right, your return is signed, your Social Security number is correct, yada, yada, yada.

2. Don’t be a millionaire. Just kidding, of course: Being rich is always a good idea. But reporting a high income will make you more likely to get audited. From a story I wrote last year called What Are Your Odds of an IRS Audit?:

• If you made under $200,000 last year, your odds of an audit are about 1 percent.
• Incomes over $200,000 but less than $1 million had audit odds of nearly 3 percent.
• With an income over $1 million, your odds of an audit increase to nearly 6.5 percent.

You don’t have to be a rocket scientist to figure out that Uncle Sam needs money, and the best place to find it is to visit with people that have some.

3. Don’t claim the earned income tax credit. Again, just kidding – if you qualify for this credit, you definitely want to take it. According to this page of the IRS website, last year more than 26 million people received nearly $59 billion from the EITC. What the credit does is provide up to $5,666 to low-income tax payers. And it’s refundable: That means you can get a check even if you didn’t pay any taxes.

Since this credit is potentially big, widespread, and refundable, it’s also a source of scrutiny. According to this IRS report, for fiscal year 2002, EITC audits recovered $850 million, and 48 preparers and 137 other people were criminally convicted of income tax fraud for EITC schemes. So if you take this credit, make sure you properly compute it.

4. Don’t file a Schedule C. Schedule C is how many self-employed people claim deductions for their small businesses. But it’s also an area so rife with overstated deductions that in 2009 the U.S. General Accountability Office put out a study called Limiting Sole Proprietor Loss Deductions Could Improve Compliance. From that report:

According to IRS estimates last made for 2001, 70 percent of the sole proprietor tax returns reporting losses had losses that were either fully or partially noncompliant.

How do you avoid what is obviously an area of IRS concern? Don’t file a Schedule C – incorporate your business and file as a corporation. Of course, forming a corporation isn’t free, and filing a corporate tax return can be trickier than filing an individual one. But if you decide to stick with a Schedule C, be prepared to back up your deductions, especially if your business is reporting a loss.

5. Report all of your income. As we recently said in the story Are We a Nation of Cheaters?, everything you make is theoretically taxable income, whether it’s reported to the IRS or not. But while you may get away with not reporting the $50 you won at poker last week, you’d best report everything you received from employment or investment activity.

IRS computers now compare nearly 100 percent of the forms submitted by income payers to the tax returns of income receivers. If your employer didn’t send you a W-2, or you didn’t get the a 1099 from your bank, that doesn’t mean they didn’t report it.

6. E-file. In the early days of electronic filing, there was a rumor that e-filed returns were more likely to get audited. That was never true, but now the IRS is virtually saying the opposite: Handwritten returns are more likely to contain errors, and invite unwanted attention. From this 2010 press release…

Other e-file benefits include a reduced error rate (1 percent compared to nearly 20 percent on a paper return), which means a decreased likelihood of hearing from the IRS.

7. Prepare an accurate state tax return. As I found out when I got audited, federal and state taxing authorities stay in touch. If your Federal return is audited, the state folks are notified – this is also true in reverse.

Bottom line? Be cautious, but not paranoid

As you read articles like this one, it’s easy to convince yourself that one slip of the mouse could result in a prison term. But the truth is that the IRS isn’t all that hard to deal with. Relatively few audits are in-depth and even fewer are in person. If your return is flagged, odds are you’ll simply get a note in the mail asking for further explanation. For example, if you forget to report some interest income, a field agent isn’t going to show up at your door: You’re just going to get a letter explaining the discrepancy and asking for more information.

Always take whatever deductions you’ve got coming. Just keep good backup, then store that backup, along with your returns, for at least three years – the normal audit limit.

But remember, if an examination reveals you’ve under-reported your income by 25 percent or more, the IRS can go back six years. And if they find fraud? If they feel like it, they can go all the way back to the first return you ever filed – or forgot to file.